Monday, November 20, 2006

Part Two: ‘An invisible hand’

The so-called invisible hand is a metaphor for the laws of arithmetic: the whole is the sum of the parts of which it consists. From this realisation (certainly obvious to Smith who was competent in mathematics, as noted by his tutors) the door opened in the next century to what was to become neoclassical economics, an approach steeped in mathematics, initially calculus (the maths of rates of change) and, later, the advanced maths familiar to every graduate student today.

Smith had this to say about the utility of mathematics, compared to its beauty and higher rational thinking:

‘It is in the abstruser sciences, particularly in he higher parts of mathematics, that the greatest and most admired exertions of human reason have been displayed. But the utility of those sciences, either to the individual or to the public, is not very obvious, and to prove it, requires a discussion which I not very easily comprehended. It was not, therefore the utility which first recommended them to the public admiration. This quality was but little insisted upon, till it became necessary to make some reply to the reproaches of those, who, having themselves no taste for such sublime discoveries, endeavour to depreciate them as useless’ (TMS IV.ii.7)

It is not that competence in mathematics deserves no respect; simply put, it is whether an exclusive consideration of concepts in mathematics (general equilibrium) that was found wanting at the end of the 19th century, really has any utility for understanding economic systems in the context of human societies in the 21st century. Answer the questions: what creates wealth and what inhibits its creation and is the answer in an equation that assumes away the social context?

Milton Friedman died this week and among the many tributes I noted a passage that struck me as thoughtful, succinct and relevant to these points:
“Friedman was providing his answer to these great issues. What was that answer? Here was the second key to his influence. His model was remarkably simple. Not only did he write with ease and clarity. The model of the way the world works was also clear to him. It was an extension of Adam Smith's invisible hand. To almost every social problem, Friedman cleverly and often brilliantly provided the invisible hand as its solution. Market forces, through competition, would distribute goods and services at the appropriate price as long as people acted in their self interest. Thus, workers would get the wages they deserved, business the profits, and growth would be maximized, creating the optimal number of new jobs given resource and technological constraints. Schooling could be subjected to this ideal solution, as could healthcare and even racial prejudice in the labor markets. The setting of currency values could be subjected to this as well” (Jeff Madrick, “Milton Friedman: a man not for all seasons”, The Huffington Post, 17 November, 2006).
Note the qualification: ‘at the appropriate price as long as people acted in their self interest.’ It exposes the weak link between the popular, near universal, association of Smith’s ‘invisible hand’ with the neoclassical certainties, as exemplified by Milton Friedman and the Chicago school.
Smith expressed his thinking by metaphor because he preferred literary perspicuity to the risk of losing his readers’ attention if he expressed it in mathematics, though he was competent in both. His audience was educated but not necessarily numerate.
His point was that unintentional motivations of individuals cumulatively account for annual total output, or its equivalent in annual revenue, represented by a metaphor, ‘an invisible hand’, in place of stating the obvious to numerate readers who understood the laws of arithmetic (a whole is the sum of its parts). Acting according to ‘their self interest’ may, and often does, compromise the potential for optimum total output.
The marginal ‘revolution’ (Walras, Edgeworth, in the 1870s) with its overriding assumptions of partial and general equilibrium, led to the excision of ‘imprecise’ literary expressions from political economy. New generations of economists, more numerate than literate, came of age with Samuelson (1940s), and were almost totally mathematical by the end of the 20th century, happily working with assumptions that mattered less than predictions, but not having any more success from researching their imaginary reality in predicting the future than they had with explaining the past.
This was their decisive break with Smith’s approach in Wealth of Nations, which was his report on the history of the creation of wealth; his books was left gathering dust on their shelves. They replaced it with purely mathematical models that studied rates of change of variables under the strictly limited assumptions of individual self-interest, maximisation under constraints, and rewards to factors. The implausibility of idealised behaviours of abstract agents, representing the humans missing from the models, was smoothed over with the brilliant device of anointing the models and their assumptions with the authority of Adam Smith’s implied blessing of ‘his’ invisible hand.
That it wasn’t ‘his’ invisible hand, but Shakespeare’s Macbeth, or Defoe’s Moll Flanders, and that he never meant his borrowing of it to be more than a mere metaphor for inescapable arithmetic of 2 + 2 = 4, is somehow lost in continuing atrocities of attribution of mystical (even religious or spiritual!) meanings to his innocent use of a metaphor for arithmetical aggregation.
I sometimes feel it is an almost hopeless struggle to remind those who forget, or don’t know, what his use of ‘an invisible hand’ means, which I come across daily and which readers of Lost legacy will be familiar with from the small selection of them that I comment upon here from the scores that I could.
Why do neoclassical, Chicago influenced, economists need Smith’s metaphor? No term for it appears in their equations, not even a ‘dummy’. It isn’t in their processes, with not even a note about it being a ‘residual’ – which is not surprising when there isn’t room for real people with their mixed motives. Their absence has no effect on the outcome (by definition), yet we know people are real, but somehow the presence of benign invisible hands, which we know do not exist, is regarded with all the reverence once accorded by ignorant pagans to invisible gods, which Smith wrote about in his ‘Principles which lead and direct Philosophical Enquiries, illustrated by the History of Astronomy’ (c. 1744-?).
But before we conclude, as many do, that somehow a non-existent metaphor has significance because Adam Smith used it, we should step back a little and note why he probably confined himself to one, and only one, use of the metaphor of ‘an invisible hand’ in Wealth of Nations, which must be surprising to those neoclassical economists who believe he had a ‘theory’ of ‘the’ (it’s always ‘the’) invisible hand of markets. Realising that he didn’t have such a theory is a small step, perhaps, but his metaphorical description of an arithmetical law of ‘one small step’ being the start of a ‘long journey’ is akin to blessing this old Chinese proverb with ‘an invisible hand’ guiding the traveller, because a ‘long journey’ is the summation of many small steps!
Why did Smith not generalise across all economic activity his use of a literary metaphor, like ‘an invisible hand’? His non use of ‘an invisible hand’ to account for the individual contributions of many merchants adding to, or reducing, the annual revenue from capital and labour is a most glaring absence. He had many opportunities in Wealth of Nations to do so. The fact is he didn’t, which belies the significance bestowed upon it by the authority of Milton Friedman or Paul Samuelson, though it was missed by Walras and Edgeworth, and the others in between.
I have not the space here, but I highlight the many instances in my forthcoming Adam Smith for Palgrave where he could have said something, even in the negative, if he considered ‘an invisible hand’ an appropriate metaphorical device or anything stronger, such as a ‘theory’. The fact is he didn’t.
Book IV that contains his critique, described, not unfairly, as a polemic, directed at mercantile political economy. Now, place a theory of self-interest, the centre-piece of neoclassical economics, into the motivations of the people driving these mercantile policies, which Smith criticises. Monopolists seek monopolies to limit or extinguish competition, polluters pollute in pursuit of their self-interest and disregard costs they impose on others, and protectionists tax or prohibit imports to raise their profits above what they otherwise would be. These activities, among others, lower the actual as opposed to the potential for economic growth and the welfare of those affected.
Each person involved in these wealth distorting activities is not acting all that differently from the merchant who prefers to invest his capital domestically rather than out of his sight and personal supervision, which are necessary features of distant trade, especially abroad. Self-interest dominates both sets of behaviours and their outcomes. Yet wealth distortion activities (monopoly, pollution and protection) benefit the individual distorter’s wealth but not necessarily the national wealth (Smith was agnostic on this point), while the competitive merchant operating locally and using his capital to employ successive rounds of labour to add value to raw materials, adds to national wealth by the laws of arithmetic (a.k.a: ‘an invisible hand’).
Whether an economy of distorters as a whole adds more to the aggregate wealth of society than an economy consisting of insecure local traders, in principle, is measurable. Smith believes that a non-mercantile economy would grow faster because regulating or proscribing into which activities capital and labour could flow, inhibits growth because costs rise above what open domestic competition and lower prices would generate, supplemented by lower cost imports. But the self interests of people prone to preferring monopoly protections are generated from the same cautious instincts that lead merchants to prefer the home to foreign trade ventures, namely security. Each is concerned about the ruin that follows from investing scarce capital in a venture where there are risks of ruin by the actions of others (competition that lowers prices of merchants with higher cost causing bankruptcy; piracy and fraud that absconds with scarce capital, etc.). These risks were compounded in the mid-18th century by the laws of bankruptcy that claimed the entire wealth of an individual to pay off debts arising from any source or for any reason.
Self-interest as the motivator for all actions of economic agents is a two-edged sword. It does not necessarily result in benign aggregate outcomes for society. It can lead to growth and opulence or stifle growth, create pollution, personal ill-health and environmental damage, prolong higher costs of consumption goods, hold up innovation and prolong unemployment. We know this because history is replete with numerous examples.
Smithian Liberty has not yet existed anywhere; the default state of perfect liberty has always been partial, differing in degree to the extent to which it is constrained by, among others, the ‘vile rulers of mankind’ through to gullible legislators. Tyranny by governments, or by landlords, merchants and manufacturers, and, in our days, oligarchs of capital and labour, communism, or religious mysticism, is more normal (in the sense of prevalent) than secular democracies and open societies that suffer none of these features of the default state.
Some neoclassical economists ignore the social, institutional and behavioural context entirely, oblivious that many of the developing economies to which they apply their models are so far removed from the conditions they assume, in order to make their equations determinate on paper, that they might as well not bother, for all the good that spending scores of millions of public money on projects that assume their assumptions hold. If property is near absolutely insecure, as it is, for example, in many parts of Africa, then postulating economies at micro- or macro-levels with behaviours as if property was secure is wasteful, where it is not a cruel deception.
However, if all the conditions of Perfect Liberty, including justice, were absolutely necessary before any economic growth could materialise, a smaller world population would still be running around as hunters and gatherers (and their lives were hardly all ‘sweetness and light’ in camps amidst Nature’s plenty). The issue is which of the possible arrangements of society – perfection or versions of the default option – is likely to promote general or partial opulence sooner, rather than later?
One thing is certain. Relying on a metaphor is not part of the solution, and Smith never said or implied that it was.


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